Volatility Swap

A volatility swap is a forward-style contract that pays a cash amount based on the difference between the realized volatility of an underlying asset and a pre-agreed volatility strike. It lets participants take a pure view on volatility without taking directional exposure to the underlying asset’s price.

Key points

Payoff = Notional × (Realized Volatility − Volatility Strike).
At inception the notional is typically not exchanged; settlement is cash based at expiry.
The volatility strike reflects the market’s expected volatility at trade start (similar to implied volatility).
Volatility swaps are OTC instruments and are commonly structured and priced by dealers.
Variance swaps (paying on variance) are more common in equity markets; they are related but not identical.

How it works

Two parties agree on:
Underlying asset,
Contract term (e.g., 3, 6, 12 months),
Volatility strike (a fixed percentage),
Notional amount (dollar value per percentage point).
Over the term, the realized volatility of the underlying is measured (see “Measuring realized volatility”).
At settlement the contract pays: Notional × (Realized Volatility − Volatility Strike). If realized volatility is above the strike, the floating (buyer) leg receives; if below, the fixed leg receives.

Measuring realized volatility

Realized volatility is typically computed from historical returns over the contract period. Common approaches:
* Standard deviation of daily log returns annualized (e.g., multiply daily std dev by sqrt(252)).
* Some contracts specify intraday sampling, exclude outliers, or annualize differently.
Precise calculation conventions are defined in the trade terms because different methods materially affect payoff.

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Example

Underlying: S&P 500
Term: 12 months
Notional: $1,000,000 per volatility point
Volatility strike: 12%
If realized volatility at expiry = 16% → payoff = $1,000,000 × (16% − 12%) = $40,000 paid to the swap buyer.
If realized volatility = 10% → payoff = $1,000,000 × (10% − 12%) = −$20,000 (buyer pays seller $20,000).

Who uses volatility swaps

Directional traders: speculate on future volatility levels.
Spread traders: seek to profit from differences between realized and implied volatility.
Hedgers: offset short-volatility exposures (e.g., short options book).

Volatility swaps vs. options and variance swaps

Compared with options: volatility swaps offer a purer exposure to volatility without directional delta exposure; options embed price exposure and require hedging to isolate volatility.
Compared with variance swaps: variance swaps pay on realized variance (volatility squared). Variance swaps are linear in variance, while volatility swaps are linear in volatility; this leads to different payoffs and replication/pricing considerations. Equity markets often use variance swaps more frequently.

Pricing and replication

Dealers typically set the volatility strike so that the initial net present value is zero. Replication and pricing commonly use a strip of options across strikes (or use variance swap replication adjusted for the convex relationship between variance and volatility). Model assumptions, option liquidity, and interpolation of strikes influence the quoted strike.

Risks and considerations

Counterparty risk — most volatility swaps are OTC.
Liquidity risk — bespoke terms can make positions hard to unwind.
Measurement risk — payoff depends on the defined realized-volatility calculation.
Model and replication risk — pricing/hedging requires assumptions and possibly dynamic hedging.
Path dependence and convexity — realized-volatility behavior and variance effects can produce outcomes that differ from naive expectations.

Summary

Volatility swaps provide a direct, cash-settled instrument to trade realized volatility versus a pre-set strike. They are useful for pure volatility views, hedging, and relative-value trades, but they carry OTC counterparty and measurement risks and require careful attention to contract terms and replication/pricing conventions.